Presentation by David Graubard, Thomson IFR Markets, Senior Analyst, Structured Finance

On May 22, 2002 JPMorgan Securities earned the honor of pricing the first senior subordinate, multi-tranche collateralized fund obligation backed by hedge fund assets for Man Group plc. Man-Glenwood Alternative Strategies CFO (MAST) was upsized to $550 million from $500 million. The U.K.-based Man Group currently has $20 billion in assets and has established itself as the benchmark issuer to beat, according to upcoming hedge fund issuers.

As if having the first issuance in a CDO asset class wasn't enough in the span of 24 hours - the following day [May 23] Credit Suisse First Boston priced Bahrain-based Investcorp's hedge fund backed CFO.

Orders were reportedly cut back on the debt in the MAST transaction due to strong demand. While there was some market chatter of insurance being used on triple-As outside of the deal documentation in the secondary market - Zurich Capital Markets has been mentioned as a possible wrapper - there has been no murmurings of JPM or Man ending up with any of the debt in inventory.

Man's triple-A, seven-year maturity notes cleared at 70 basis points over six months Libor, out from price talk of 55 basis points, which at the time was in line with real estate CDO pricings and issues from off-the-run managers.

CDO of CDO buyers reportedly expressed interest in the triple-Bs of Man-Glenwood's CFO at 300 basis points over six month Libor since the deal is far less leveraged than other CDOs - 30% equity versus 5% in a cashflow investment grade CBO. Nevertheless, some investors expressed concern that there was only a Moody's Baa2' rating on the bottom debt tranche, which kept them participating.

Although, Investcorp's Diversified Strategies CFO was scaled down from $500 million to $250 million, its triple-As priced at 60 basis points over six-month Libor, helped by the fact the transaction had a five-year expected maturity - two years shorter than MAST.

Diversified Strategies' had an all-in cost of debt of 110 basis points. Man, other hand, was able to execute a larger deal, but at a larger cost, with a weighted average cost of debt of about 120.

Currently, new CFOs planning to come to market are facing a weighted average cost of debt of at least 140 basis points, according to one prospective CFO issuer with several billion under management and a lengthy and impressive track record. CFOs triple-As could see pricing as wide as 75 basis points over Libor, 5 basis points back from the Man benchmark.

Lessons learned

If what people say is true, that it took Man about nine-months to get its equity orders lined-up, smaller players with shorter track records are likely to have a challenging experiencing bringing deals to market. One key ingredient that Man and Investcorp shared was a strong retail network of high net-worth individuals, which according to many was the driving force behind placing the equity in their deals.

"Institutional portfolio managers are not going to make a career-breaking decision to invest in the equity of a deal that will catapult their portfolio average over the market mean, when they can buy other products, or buy the debt of a CFO, and clear market indices, looking like heroes and not have risked their careers over it," explained one potential issuer.

Live deal

Currently there are only two visible live CFO deals aggressively making the rounds with an array of equity investors: UBS O'Connor's UBS Alpha CFO Ltd. (see side bar) and Concordia Advisors' Concordia Funding Ltd. Concordia Funding Ltd. is a $100 million, 3-year expected final, fund of a fund market value transaction, referencing a single portfolio of G-10 government fixed-income securities.

The reference fund is Concordia Advisors, LLCs G-10 Relative Value Strategy, a fixed-income market neutral arbitrage product referencing government securities. The two-tranche, uninsured transaction has an expected debt rating of Aa3' on the $80 million senior tranche. The equity tranche is $20 million in size and is now said to be marketing in Europe and Asia. The legal final is five years. The issuer and underwriter could not be reached for comment.

Salomon Smith Barney's second transaction is a $400 million issue for a European fund of fund manager. This deal is a CFO backed by multiple hedge funds and strategies, similar to JPMorgan's blowout for Man. Coast Asset Management is in the market with a wrapped multi-tranche CFO via Merrill Lynch and is marketing equity. Bear Stearns also is said to have a multi-tranche CFO in the pipeline that is expected to have a synthetic super senior credit default swap tranche. Commerzbank is reportedly working on a similar derivative CFO of hedge funds that will use a synthetic and funded structure. Goldman Sachs is said to be beating the bushes for a pristine mandate for a CFO; whether they have found one is yet to be determined. Grovsner Asset Management with its several billion under management have had a tranched CFO deal in equity marketing for many months via Morgan Stanley. Currently sources say the firm is debating whether to take the path of least resistance and come out with a principal protected deal or a tranched CFO. Ivy Asset Management has a similar mandate to be given for a CFO transaction, however, the firm may wait out the current volatility in the market before making a move.

The skeptics - those who looked but said no

There is a very limited supply of fund of fund managers able to convince the buyside, rating agencies, and the high net worth investment community that they should put their time and money in a CFO. Some extremely well-known hedge fund of fund managers have been unable to place tranched CFOs, and eventually took the path of least resistance - senior/junior tranche principal protected deals. The following are comments investors have made regarding why they didn't invest in recent CFOs that have been pitched to them:

*"There is a limited first-mover advantage for the investor, and rating agencies have been wrong before in new asset classes - e.g. franchise ABS."

*"Currently these deals are like investing in a blind pool of assets - there's [virtually] no policing of the individual hedge funds making up the deal."

*"Statistics can prove anything, and there is not much else to base the investment decision on."

*"I would rather give my money to a fund of fund manager direct and be able to pull out whenever I want, rather than lock in an investment for five to seven years in a CFO."

Going forward

In the first half of2002 we saw two tranched, uninsured hedge fund CFOs, and two to four more is possible for the year. Fund of fund managers will increasingly take the path of least resistance and issue principal-protected, senior/junior tranche CFOs in the private market. In the current environment, asset managers will be compelled by the diversity that a CFO offers, especially those managers long in investment-grade corporate credits.

Lastly, the concern of investors is that there is a lack of transparency in the hedge fund CFOs that will need to be addressed before we see meaningful deal flow.

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